A financial independence journey fueled by passive income

Annuities

The following is a guest post from Brian So, financial advisor and blogger at AAFS InsuranceWhen asked about their plan for their RRSP at the end of the year in which they reach age 71, most people’s response would be to simply transfer their assets into a RRIF. But did you know there is another option? An option that provides guaranteed income for life and removes all investment risk? I am talking of course about life annuities. This post will explain the basics of life annuities to help you decide if they fit into your portfolio.

Life Annuity Basics

You can think of a life annuity as the opposite of a life insurance policy. With life insurance, you pay a premium every year and in return, the insurance company pays your beneficiary a lump sum amount when you pass away. With a life annuity contract, you give a lump sum amount to the insurance company, which promises to pay you an annual income until you pass away. The longer you live, the more money you’ll receive. If your family has a history of long life and you’re in good health, you’ll benefit from more payments than someone who isn’t blessed with longevity.
The amount of income you receive is based on several factors, including the lump sum amount deposited, interest rate, your age and sex. A younger person is expected to live longer than an older individual and females also have longer life expectancies than their male counterparts. What this means is that a young woman will receive a lower income than an older man, since they are expected to collect payments for a longer time period.

Annuity payouts are also based on the prevailing interest rate. The higher the interest rate, the higher the payment and vice versa. This may be a turnoff to most dividend investors given that the yields of long-term risk-free fixed income assets pale in comparison to many dividend stocks. But in exchange for a lower return, annuities provide income that is guaranteed for life while also eliminating investment risk. And the amount of income generated by an annuity isn’t something to scoff at either. For a $100,000 lump sum amount, Sun Life is currently paying $6,497 annually on a straight life annuity for a 65 year old male. Not bad considering an equivalent amount deposited into a 5 year GIC currently only pay $2,000 annually.

Taxation of Annuities

An annuity purchased with registered money pays out income that is fully taxable, like any other type of withdrawal from a RRSP or RRIF. Taxation of non-registered annuities is treated differently. It’s important to understand that payments are comprised of interest and return of capital. Interest is fully taxable while return of capital is received tax-free. When you purchase a non-registered annuity, you have a choice between reporting tax with the prescribed or non-prescribed method. With a prescribed annuity, the interest component remains level throughout the life of the contract. But a non-prescribed annuity begins with a higher proportion of interest, which gradually lowers over time.

Using the example above, the amount of interest reported via the prescribed method is $682, which remains level for the life of the contract. The amount of interest reported using the non-prescribed method is just under $3,500 in the first year, and gradually decreases over time.

How to further lower your risk

Some people avoid annuities because they think that payments stop immediately after death and are worried that they will ‘lose’ to the insurance company if they pass away soon after purchasing it. While this is true with a straight life annuity, a guarantee period can be chosen to reduce the risk. For example, with a guarantee period of ten years, payments must be made to you or your beneficiary for at least ten years. If you pass away before the expiry of the guarantee, the income stream will continue to your beneficiary until the guarantee period ends.

Another way to ensure income continues after your death is to purchase a joint life annuity as a couple. This allows for payments to continue to the surviving spouse at a reduced rate. Both of these methods transfer risk from the annuitant to the insurance company. As a result of the guarantees, the insurance company will reduce the amount of income paid out compared to a straight life annuity.

Drawbacks of life annuities

Since this is an investing blog, I should discuss some of the risks involved with owning a life annuity. Like other fixed income investments, annuities are not immune to inflation risk. With a planned retirement time frame of 25-30 years for most people, receiving steady but unchanging income means your purchasing power will gradually diminish over time. This can be offset by purchasing an annuity with an indexing option, but in return your initial income will decrease dramatically.

Another disadvantage is the loss of control over your money. Once you give the insurance company your money, there’s no way to withdraw the entire amount. All you’re entitled to is the regular stream of income. If an investment opportunity or emergency comes up, you’re out of luck. This is another reason why diversification is key and you shouldn’t put your entire retirement savings in an annuity.

In summary, although they are not considered fixed income, annuities display the similar feature of smoothing out your portfolio’s overall performance. As you enter the drawdown phase of life, you can consider annuities as an investment alternative capable of balancing your portfolio.

Brian So is an insurance advisor, future CFP and blogger at http://aafsinsurance.com. His areas of expertise include retirement planning, tax savings and insurance advice. If you want to hear his thoughts about the world of personal finance, follow him on Twitter.

Securing your future financially can be an overwhelming task. Although saving is crucial for all of us, it is especially important for those us of getting ready for retirement. Buying an annuity is one way to make the saving process easier.

The best way to buy annuities is to know as much about them as you can to make an informed decision. Here is what you need to do before buying an annuity for your retirement:

Shop Around

Don’t commit to the first insurance company you contact about buying an annuity. Ask to speak to someone about the type of annuity they could offer you, what it would cost you and its advantages and disadvantages. Let the company know you will be in touch, and gather between three and five quotes from different companies and compare your options.

Compare interest rates, commission fees, surrender charges and other fees that would apply in the event that you need to withdraw from your annuity early or sell your annuity in the future.

In the event that you need to forgo the annuitized payments and you decide to cash in your annuity for a lump-sum payout, each company may penalize you differently. Make sure you know the terms and conditions of each contract and decide which one is the right one for you.

Know How Much You Need for Retirement

Look at your current lifestyle and project what you would need from retirement income. Factor in other sources of retirement income, such as Social Security, to determine what your long-term financial goals are for your annuity.

This will give the insurance company a better idea of what kind of annuity is right for you, and you can make a more informed decision if you know what you expect to invest in a certain amount of time.

Buy From a Reputable Company

Insurance companies that buy and sell annuities are not created equal. A referral from one of your friends may be a good place to start, but what works for your friend may not work for you. Make sure the insurance company you buy your annuity from is highly rated by a financial institution rating agency, such as Standard & Poor’s, Fitch, AM Best or Moody’s.

You can obtain a professional rating by calling the insurance company directly or by visiting a financial institution rating agency’s website.

Know the Terms and Conditions Before You Sign

This shouldn’t be a problem if you buy your annuity from a reputable company, which will go over the contract in detail with you, but it is always good to read the contract in its entirety and ask questions about anything you don’t fully understand. You can even have your contract reviewed by a financial adviser to make sure there are no hidden fees or fine print.

Annuity terms and conditions may vary depending on the insurance company you are working with, but here a few general things you should know:

All annuities grow tax-deferred.

You cannot withdraw from an annuity before you reach age 59½ without penalty.

All annuities provide options during the income phase based on how you want to receive your money.

There may be fees involved if you withdraw early or sell your annuity in whole or in part.

Purchasing an annuity should give you some financial relief for your future. To ensure you make the best decision for your retirement, be informed on your decision before you sign on the dotted line.

Kaitlyn Fusco is a content writer for Annuity.org. She combines her interests in writing and overcoming debt to inform the public about issues related to credit, debt, annuity and personal finance.